The Concept of Mutual Fund - Essay Example

MUTUAL FUNDS Introduction One important concept which always has been spoken when people talk about the finance and financial details is the concept of mutual fund. Before really moving into the discussion about mutual funds, we will bring the basic definition of other related but important concepts of stocks and bonds. Basically we define each of them so that understanding of the whole concept of mutual funds become much easier. So a stock represents shares of ownership in a public company. Few of the companies which can be called public companies are Accenture, IBM and Ford etc. similarly we can outline the concept of bonds. Bonds gives people chance to lend our money to the government or a company. We receive interest and principle back over pre-determined amount of time. We can say that bonds are the most common lending investments traded on the market. Other than shares and bonds there are other types of investments like real estate and precious metals but it is generally perceived that mutual funds mostly invest in stocks and bonds. Definition of Mutual Fund Many definitions have written by people but essentially all dwell upon the same idea regarding its concept. So a mutual fund can be defined as a financial intermediary that allows a certain group of investors to pool their money together with a pre-determined investment objective. Here in mutual fund there exists a fund manager who trades the fund's underlying securities. He then can realize capital gains or loss and then collects the dividend. Whenever we invest in a mutual fund, we are buying shares of the mutual fund and thus in the process becoming a shareholder of the fund. After the dividend income is found, the investment proceeds are then passed to the individual investors. We then calculate the value of the share of the mutual fund which is known as net asset value. The main reason why the mutual funds have become important and at the same time regarded as one of the best investments ever created is that mutual funds are very cost effective and also they are quite easy to invest. Another Advantage is that in the process of pooling money in a mutual fund, the investors can buy stocks or bonds with less trading costs than before. Regarding its value in different countries we can say that it is one of three types of investment companies in the United States and outside United States & Canada mutual fund can termed as generic word for various types of collective investments. Types of Mutual Funds There exist few common types of mutual funds and they are outlined as follows: Money Market funds, fixed income funds, equity funds or growth funds, balanced funds, global funds, specialty funds and index funds. Lets describe each of them briefly so as the understand the whole concept clearly. Monet Market Funds: These are generally perceived as low risk funds offering low returns. These are a type of mutual funds that invest in a short term debt securities of agencies like banks U.S Treasury bills. They have advantages of being widely used, low risk and highly liquid in nature. Fixed income funds It is a type of mutual funds which invest in debt securities like bonds and mortgages. The main goal is to provide the investors with regular income with low risk. Here in this type fund values fluctuate in response to changes in interest rates Equity Funds Equity funds are also called as growth funds. It invests primarily in common shares. The goal is to have long term growth because the value of the assets held usually increase over time. Some funds focus on blue chip companies and others on smaller companies. Balanced Funds It invests in a balanced portfolio of equities, debt securities with the goal of providing reasonable returns with low to moderate risk Global and foreign funds It is a type of mutual fund which may be fixed income or growth or balanced funds and which invest in foreign securities. Specialty funds It is a type of mutual fund which invests primarily in a specific geographic location or a specific industry. Index funds It invests in a portfolio of securities selected to represent a specified target index like S&P index. Thus in this way we have discussed about the different types of mutual funds. Investments done by Mutual Funds The two major investments which are done by mutual funds are Stocks and Bonds. Although we have mentioned about them previously in the introductory note, we will explain it again to gain clarity in understanding the whole topic.A bond can described as a debt security in which the issuer owes the holders a debt and is entitled to repay the principal and interest at a future determined date which is termed as maturity. There might be other related issues attached to it, which are based on the situation present. Usage of bonds enables the issuer to finance long term investments with external funds. Few important features of bonds which are worth mentioning are the maturity date, face amount, coupon and coupon dates. It is understood that bond markets rise when stock markets go down and thus they are perceived as safer investments than stocks. However bonds might be risky. Bonds suffer from volatility and their interest payments are higher than dividend payments. Stock can be defined as the capital which is raised by a company through the distribution of shares. The following are the investments which are done by mutual funds. They are Stock funds and Bond funds. A stock mutual fund invests its money in the stocks of the individual companies. The main categories of stock funds are growth funds and international funds. Bond Funds: A bond mutual fund invests its money in bonds of companies or governments that are as varied as stock funds investment. One difference is that bond funds tend to be more conservative growth of an investor's portfolio. Some of the categories of bond funds are government bond funds, municipal bond funds and corporate bond funds. Bond funds also come in different maturities like short term bond funds, intermediate bond funds and long term bond funds. Mutual Funds Operations The main things which mutual funds should consider are Net Asset Value, Turnover and expense issues. Net Asset value or NAV is defined as fund's value of its holdings and which is usually expressed as a per share amount. Usually the NAV value is determined on day to day basis for most of the funds, but there are few funds which determine its value multiple times on a single day. Funds which are classified as open end funds sell and redeem their shares at the NAV and funds which are classified as closed-end funds trade at higher or lower price than their NAV. This is called as premium or discount depending on the situation. Another important operation funds uses is Turnover. Turnover can be defined as a measure of the fund's securities transaction. It is considered as annual value and is expressed as a percentage of the net asset value. The turnover value is usually calculated as the value of all the transactions which are considered in the whole process and this is divided by 2 and which is further divided by the fund's total holdings. Whenever we consider turnover value we also need to understand that the turnover has taxes in addition for funds which are passed through to investors. Another important issue to be considered is the expense values. Mutual funds also bear expenses in a same fashion as other companies. The basic structure of a mutual fund can be divided as management fee, non-management expenses and 12b-1/Non 12b-1 fees. All these expense issues are expressed as a percentage of the average daily net assets of the fund. These issues are outlined in brief. The management fee for the fund is usually spoken at a same level as the contractual advisor fee which is charged for the investment management. Sometimes for better understanding of the whole scenario management scenario is defined as contractual advisor fee and contractual administrator fee. The advisory fee is usually structured as flat rate fees. However, many funds have contractual fees which include breakpoints, such that as the assets of the fund increase, the advisory fee paid decreases. Thus in this way management fee concept has been discussed. Non-management expenses are those which funds themselves must pay unlike management fee where advisor and administartor role comes into picture. Some of the more important non-management expenses are: Transfer Agent expense, custodian expense , legal/audit expense, registration expense, trustees expense and printing/postage expenses.12b-1 service fees are contractual fees which a fund may charge to cover the marketing or shareholder expense for the fund, while non 12b-1 fees are shareholder service fee which do not fall under sec rule 12b-1. Thus in this way we have outlined the operations of mutual funds. Mutual Funds & Commercial Banks It is known fact that commercial banks all over the world have entered the area of the mutual fund industry and they also joined the league wherein they started giving mutual funds under the headlabel of the bank but we need to understand the diffrence between a commercial bank selling mutual funds under bank name and mutual funds. The major difference is that mutual funds sold in banks, which may include money market funds and which are not the bank deposits, also money market fund is different from money market deposit account. A money market fund is a type of mutual fund. It is not guaranteed, and comes with a prospectus whereas a money market deposit account is a bank deposit and it is guaranteed and comes with a truth in savings form. Also the funds in the bank are not federally insured by the Federal Deposit Insurance Corporation. Mutual Funds & Non Depository Institutions Till now we have discussed about the nature of mutual funds, types of mutual funds , investments done by mutual funds and operations of mutual funds. Let's broaden the horizon by looking the bigger picture and here we consider the nature of non depository institutions . A non depository institutions can be defined as those insititutions or companies that make loan but do not take deposits . few of the examples of non depository insitituions are insurance companies, credit card comapanies. Basically their idea of getting funds is that they issue bond or commercial papers instead of taking deposits and this where mutual funds are different. They are form of a collective investment which takes money from many investors and invests the money in different forms and thus it uses the concept of diversification wherein it speaks of the idea of spreading the money across many different types of investments. This whole concept reduces the risk tremendously and this concept is absent when we consider non depository institutions. Thus in this was we have outlined the idea of non depository institutions and the difference between mutual funds and non depository insitutions. Thus in this we have discussed all the basic details which cover the idea of mutual funds. References: 1. John Bogle (1999) Common Sense on Mutual funds: new imperatives for intelligent investor. New York: Wiley 2. Bruce Sanklin (2003) what all stock and Mutual fund investors should know. Denver: Sankin Associates 3. Esme faerber (1999) All about Mutual Funds. Chicago: McGraw Hill 4. Irwin Friend (1996) Mutual Funds: New Perspectives. London: McGraw Hill Read More